Owners’ compensation can be a subjective — potentially contentious — issue when valuing a closely held business. Here’s an overview of how business valuation professionals evaluate and adjust for owners’ compensation when assessing normalized earnings. Learn more from the experts at Hall Kistler below.
The Link Between Owners’ Compensation and Value
Under the fair market value standard, the focus is on what a hypothetical buyer and seller would agree to. When it comes to compensation, how the current owner of a business chooses to structure it might be very different from what hypothetical parties would agree to. Private companies often set compensation levels without referencing market norms, instead basing pay on cash flow needs, tax strategy or lifestyle considerations.
If owners’ compensation isn’t adjusted to market levels, the company’s reported earnings may not reflect what a hypothetical buyer would actually receive. Some owners pay themselves above market levels, which can depress reported earnings and, if not adjusted, lower the company’s value. However, the reverse may be true for those who take only modest salaries.
Beyond Salaries
Before estimating reasonable (or replacement) compensation, it’s critical to capture all the various types of payments that companies might make to owners, including:
- Direct salaries, bonuses and commissions,
- Stock options, contingent payments or change-in-control arrangements,
- Shareholder loans with low (or no) interest and other favorable terms,
- Company-owned or leased vehicles and vehicle allowances,
- Reimbursements for moving and relocation expenses, subsidized housing, and education costs,
- Excessive life insurance or disability payments, and
- Other perks, such as cafeteria plans, athletic club dues, vacations, discounted services or products, and contracting work done at (or below) cost.
Owners’ compensation may also be buried in such items as management and consulting fees, rent expense, noncompete agreements and other related-party transactions.
Objective Resources
When evaluating owners’ compensation, valuators may turn to IRS guidance because it provides a well-developed, widely cited framework for determining what’s reasonable. This guidance can help support valuators’ conclusions in legal disputes, due diligence and other situations where compensation levels may be challenged.
The IRS has published a job aid to help its agents evaluate an owner’s total compensation package. It defines reasonable compensation as the amount that “would ordinarily be paid for like services by like enterprises under like circumstances.”
The job aid recognizes that compensation levels can vary substantially depending on such factors as:
- The individual’s role in the company,
- External comparisons of the salary with amounts paid to similar individuals in similar roles,
- The character and condition of the company,
- Potential conflicts of interest between the individual and the company, and
- Internal consistency in how employees are compensated.
Owners can control compensation, and that creates an inherent conflict of interest. External comparisons are key to supporting reasonable compensation levels. The IRS job aid recommends interviewing owners to get a clearer picture of their experience, duties, knowledge and responsibilities. It also lists several sources of objective market data that can be used to support reasonable compensation levels, including salary surveys published by trade groups or industry analysts, proxy statements and annual reports of public companies, and private company compensation reports.
Get it Right
Owners’ compensation is more than a tax issue. It can be a matter of debate in mergers and acquisitions, divorces, shareholder disputes and other litigation matters involving the value of a private business. An experienced business valuation professional understands how to develop a market-based estimate of reasonable compensation. He or she then can compare that estimate to owners’ actual compensation and make adjustments as needed to effectively estimate the business’s value. Contact the experts at Hall Kistler for help determining reasonable compensation and appropriate adjustments for valuation purposes.